A recent IRS Private Letter Ruling dealt with the need to change an error in the drafting of an irrevocable trust in order to repair tax issues with the trust. While an irrevocable trust normally cannot be changed after it is executed, there may be situations where a change might be possible. Also, some states, either by common law or statute, an irrevocable trust can be modified for a variety of reasons.
Recent Private Letter Ruling
Private Letter Ruling 201544005 (Jun. 19, 2015), involved an irrevocable trust that had a couple of flaws. The settlors (a married couple) created the trust for their children and the couple were also named as trustees. One problem was that the trust terms gave the settlors a retained power to change the beneficial interests of the trust. That resulted in an incomplete gift of the transfer of the property to the trust. In addition, the retained power meant that I.R.C. §2036 came into play and would cause inclusion of the property subject to the power in the settlors’ estates. The couple intended that their transfers to the trust be completed gifts that would not be included in their gross estates, so they filed a state court petition for reformation to correct the drafting errors. The drafting attorney submitted an affidavit that the couples’ intent was that their transfers of property to the trust be treated as completed gifts and that the trust was intended to optimize the couples’ applicable exclusion amount. The couple also sought to resign as trustees. The court allowed reformation of the trust. That had the result of fixing the tax problems. The IRS determined that the court reformation would be respected because the reformation carried out the settlors’ intent.
Decanting – Changing Course With an Irrevocable Trust
Can an irrevocable trust be changed for reasons other than to fix a drafting error as was the case with the private letter ruling? The answer is, “it depends.” Some state courts have held that a trustee’s authority to distribute trust corpus means that the trustee has a special power of appointment which allows the trustee to transfer all (or part) of the trust assets to another irrevocable trust for the same beneficiaries. So the concept of “decanting” involves pouring one trust into another trust with more favorable terms. The authority of the trust to “decant” comes from either an express provision in the trust, or a state statute or judicial opinion (common law). Presently, approximately 20 states have adopted “decanting” statutes, and a handful of others (such as Iowa) allow trust modification under common law.
What are common reasons decant an irrevocable trust? Some of the most common ones include the following:
- To achieve greater creditor protection by changing, for example, a support trust to a discretionary trust;
- Change the situs (jurisdiction where the trust is administered) to a location with greater pro-trust laws;
- To adjust the terms of the trust to take into account the relatively larger federal estate exemption applicable exclusion and include power of appointment language that causes inclusion of the trust property in the settlor’s estate;
- To provide for a successor trustee and modify the trustee powers;
- To either combine multiple trusts or separate one trust into a trust for each beneficiary;
- To create a special needs trust for a beneficiary with a disability;
- To permit the trust to be qualified to hold stock in an S corporation; and
- To correct drafting errors that create tax problems and, perhaps, in the process of doing so create a fundamentally different trust.
The ability to modify an irrevocable trust is critical. This is particularly true with the dramatic change in the federal estate and gift tax systems in recent years. Fortunately, in many instances, it is possible to make changes even though the trust is “irrevocable.”